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Personal Debt Management

Case study:

£6000 Debt Grew To £116 000:
If you don’t repay a loan, and a lot of time passes, the debt can grow to unmanageable proportions, as happened to an unfortunate borrower in Manchester in the United Kingdom. A grandmother has been forced to put her house up for sale after she ended up owing a massive £116 000—on a £6000 loan. Esther Osei, 57, borrowed the money in 1988 to pay for her father’s funeral and to buy a new cooker for her Clayton home. But she could not meet the cost of the loan and 18 years later, the amount she owed had grown to £116 000 … Esther said: ‘I borrowed the money when I was grieving for my father. I just signed the papers.’
When the lender applied to take possession of her home, Esther sought help by going to the North Manchester Law Centre. Lawyers negotiated a deal at Manchester County Court . . . A law centre spokesperson said Esther should never have entered into the loan agreement. ‘It was a very high rate of interest.’

Required:Based on the case study, prepare a report (or essay) that highlights the main issues.

Answer

Introduction 

In this analysis, the focus is mainly on the loan that was taken by a person for the completion of her father's funeral. The loan was taken 18 years ago. The amount of the loan was £6000, which was increased to £116000. As the person was in terrible need of money she did not read all the schemes and instruction, which included a rate of interest, was too high for her standards. The analysis is done to observe that how could have the total repayable amount grown that much. It is also to be analysed that what finance formula did the company used to calculate the loan amount, what was the exact interest rate that was charged in the amount, what was the main issues that forced the person to take the loan in a desperate manner. As the analysis proceeds it is also important to think of a recommendation for the person, which would help her in this case. The recommendations should be as simple as possible, effective in every situation, valid and legal from law’s point of view. 

Issues for enhancement of loan amount 

As a person takes a certain amount of loan from an organisation it is from that day several processes are followed by the organisation in order to calculate the amount which will be repaid by the loan taker. The major reasons that affect the enhancement of the loan amount is as follows -  

Interest rate  

At first, the main concern before taking a loan should be the interest rate that is going to be charged by the organisation against the amount. The loan taker is to read all the documents that are related to the loan taking process, in order ensure that the rate is in the person's limits and standards. Due to lack of knowledge, some loan taker suffers huge problems regarding loan amounts and rates especially those who did not read all the documents clearly. According to Keynes (2016), the interest rate on a loan is the key factor that could affect the loan taker to redeem the loan amount. In this regard, it is to mention that the high-interest rate enhances the redeemable amount of a loan. On the other hand, it is to state that the interest on loan could be paid either annually or it accumulates with the principal amount of loan.

Term of loan 

In order to determine the total amount of repayable loan term of a loan is a basis of such calculation. The loan taker needs to be aware of that the term of the loan can affect the outcome of the amount that will be charged. The related documents reveal the terms and conditions that will be applied in the process, which is to be carefully observed. As the term of the loan increases the amount of the repayable amount multiplies with the same, so it is important to decide what will be the term of a loan. As it is not decided accordingly to the limits and standards of the loan taker, it would be a major issue for the loan taker to repay the loan amount. According to Agapova & McNulty (2016), it is important for every person to calculate the term duration accordingly to the own standards and strengths.

Interest charging process

The most important and complicated factor in terms of loan calculation is the interest charging process and the financial formulas. The interest charging process is needed to be explained in details in order to ensure that the persons who have applied for loans are able to understand and decide properly, what it will be the outcome of the process. The loan takers need to have a clear idea of what are the interest charging process is, and how it calculates the loan amount. A brief description of every individual is needed to provide, that which interest charging process is going to be applied for the individual's loan. There are several divisions of the interest charging techniques, which applies different type’s changes in the loan calculation process. Hence, it is important for the loan taker to have all the detailed information of the loan process.  

Simple interest or compound interest 

Mainly two types are charged in the loan calculation process, which is the simple interest process and the compound interest process. At the beginning, it is critical to have a clear understanding of these formulas, which will be affecting the amount. The simple interest is rather easier to understand. It is also very smooth in calculating and recording the amounts in the process. The most preferred interest process by the loan takers, as it is simple and easy to understand. The total amount which arises in this calculation is often within the limits of common peoples and can smoothly repay. Simple interest calculates a certain percentage to calculate the loan amount charged against the loan amount at a fixed rate annually (Drake, 2011). For example, if the loan amount is 100 and the rate of interest is 10%, the calculation under this method is as follows

100*10/100= 10, therefore the annual amount of interest that will be charged is 10. It will continue throughout the years with the same amount till the repayment date.

Loan takers are less willing to accept this process as the applied formula against their taken loan, as it is hard and complicated to understand and maintain,also the final amount that arises from this calculation is above common people's reach. Peoples find it difficult to repay such loan amounts and are not in favour of this method. The rate of interest is multiplied over the years with the principal amount. 

100*10/100= 10, therefore the interest amount for the1st year will be 10

110*10/100= 11, so the interest amount for the 2nd year will be 11, it will continue to multiply over the years till the redeemable date.

Main issues for enhancement of loan amount from £6000 to £116000 

In the case study, it has been seen that the person has taken the loan of GBP 6000 before 18 years. In this regard, it is to mention that the loan taker has not paid any instalment of the loan. Therefore, it can be said that the interest on the loan has been accumulated for the above mentioned period. Therefore, the issue is the accumulation of principal and interest over a long period of eighteen years. This accumulation of the initial amount of loan and the interest has resulted in enhancement of loan by GBP 110,000.

Main issue

  1. The high term of loan: In the      present scenario, it has been seen that the loan taker has taken the loan      eighteen years back. In this context, it is to mention that the high term      of a loan could result in high repayment amount. According to Laubach      & Williams (2016), a high-interest rate is counted as the effective      factor for making repayments as an amount of interest rises with the term      of a loan. In this regard, it is to mention that the interest on the loan      has been accumulated with the principal amount for eighteen years.      Therefore, the interest has become more than the principal amount. The      person has taken a loan of GBP 6000 the repayable amount has become GBP      116,000. Therefore, it is to mention that the person is to pay an interest      of GBP 110,000 (GBP 116,000- GBP 6000). Hence, it can be said that the      high term of loan has resulted from a high amount of repayable amount. 
  2. Compounding of interest: As opined      by Guariglia, Spaliara & Tsoukas (2016), the compound interest concept      is used for charging interest on loans taken from financial institutes. In      this regard, it is to mention that the company has charged interest by      considering the compound interest, and therefore, it has considered the      principal amount and the interest of previous year for computing the      interest for an accounting year. As the compound interest system considers      the loan amount and the interest accumulated on such loan as the base of      interest calculation (Figure 1), this method results in higher return as      compared to the simple interest. Thus, it can be said that the loan taken      is to pay GBP 116,000 against the loan of GBP 6000 due to the adoption of      simple interest by the company, which has given the loan. In this context,      it is also to mention that the company has used the compound interest      formula which is as follow.

A = (1+i)n

Where A = Amount to be repaid, 

i = Rate of interest charged against the loan,

n= Term of loan. 

From the above formula, it is to disclose the following fact.

Interest = Opening balance of the loan * rate of interest.

The opening balance of the loan is calculated by adding the interest of previous year and the principal amount. Therefore, it can be said that the company has used the compounding formula for charging interest.
  


Figure 1: Comparison of simple and compound interest

(Source: Rostamkalaei & Freel, 2016)       

  1. High-interest rate: Apart from the high term of the loan, the enhancement of loan amount could be considered as the result of high rate of interest. In this regard, it is to mention that the company could have charged a high-interest rate, which resulted in a high amount of loan after eighteen years. As cited by Boot & Ratnovski (2016), the repayable amount of loan depends upon the interest rate and rise in interest rate could cause the increase in the amount of loan. As the company has adopted compound interest technique, the interest could be calculated by using the following formula. 

Formula

 

Figure 2: Formula for interest under compound interest method

(Source: Grinblatt & Titman, 2016)

Rate of interest


Particulars
Details
Future Value (FV)
£  116,000.00
Present Value (PV)
£      6,000.00
Term of loan (n)
18
r (Rate of interest) = (FV/PV)1/n   - 1
17.89%
=(GBP 116000/ GBP 6000)1/18   - 1

Table 1: Computation of Rate of interest charged by the company 

(Source: As created by the researcher)

From the above discussion and formula, it is to mention that the company has charged an interest at the rate of 17.89% per annum. On the other hand, it is to mention that the company has charged the interest by considering the compound interest method. For this reason, the computation has been made by taking GBP 116,000 as the future value as the loan taker has to repay this amount to the company from, which the loan was taken. On the other hand, it is to mention that the initial amount of loan, which was GBP 6000 has been considered as the present value as per the principle of compound interest (Bennett & Kottasz, 2012). By applying the above-mentioned formula, the interest rate has been calculated at 17.89% per annum.


Conclusion and recommendations

From this analysis, it is observed that the reason of the increment of the loan amount to such a high amount was due to the long time in which the loan amount was remained unpaid. The loan taker needs to be aware of that the term of the loan can affect the outcome of the amount that will be charged. As the term of the loan increases the amount of the repayable amount multiplies with the same, so it is important to decide what will be the term of a loan. The term of the loan was remained unpaid for 18 years which caused the enhancement. The rate of interest which was charged in this contest was almost 18% to be specific 17.89%, which is a very high rate for any common person. The organisation charged compound interest which is as discussed above is complicated and fairly high. 

After the analysis is done and observed it is understood and recommended that if a person generates loan from any organisation, the person need to be focused on repaying the loan as soon as possible. It is also important for the person to understand and decide loan amount according to the interest rate and the interest charging process which will be charged against his/her loan amount. 

 

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